--- title: "Cost of Goods Sold (COGS) Explained With Example | MCC" description: "What belongs in COGS, the formula, perpetual versus periodic, and a worked inventory example with margin." url: "https://mcc-solutionsnj.com/bookkeeping/guides/cost-of-goods-sold-explained" --- Bookkeeping guide · Updated October 12, 2026 # Cost of Goods Sold Explained for Small Business Cost of goods sold, or COGS, is the direct cost of what you sold. It is the first thing subtracted from revenue, and the result, gross profit, tells you whether your pricing and purchasing work before overhead enters the picture. By [Matthew Coleman](/about), MCC Solutions **Quick answer.** Cost of goods sold is the direct cost of what you sold: inventory purchase cost, freight in and direct production labor and materials for a product business, or subcontractors and materials used on jobs for a service business. Subtract it from revenue to get gross profit. Want this handled for you? Monthly bookkeeping, cleanup and year-end close for small businesses. Start with a free health check of your books. [Free health check](/bookkeeping/health-check)[Get a quote](/bookkeeping/#interest) **Related:** [NJ 1099 contractor rule (ABC test)](/bookkeeping/guides/nj-independent-contractor-rule-abc-test-2026) · [Trial balance explained](/bookkeeping/guides/trial-balance-explained) · [Owner contribution or loan](/bookkeeping/guides/owner-equity-and-capital-contributions) **Free tools:** [Was that craft fair worth it?](/bookkeeping/craft-fair-profit-calculator) · [Free invoice template](/bookkeeping/free-invoice-generator) [![Intuit ProAdvisor Gold tier badge](/img/credentials/intuit-proadvisor-gold.png)](https://proadvisor.intuit.com/app/accountant/search?searchId=matthew-coleman77)Gold tier in Intuit's ProAdvisor program. [See my Intuit listing](https://proadvisor.intuit.com/app/accountant/search?searchId=matthew-coleman77) Keeping your own books? Tallyfinch does invoices, bank import and reports on your computer. [See Tallyfinch](/bookkeeping/mcc-books-downloadable-bookkeeping-software) ## What belongs in COGS For a product business, COGS includes the purchase cost of inventory sold, freight in, and direct production labor and materials if you manufacture. Packaging that goes with each sale often counts too. For a service business, COGS may include subcontractors and materials used directly on jobs. It does not include general overhead like rent for an office, marketing, or administrative salaries. Those are operating expenses. ## The basic formula For inventory businesses: beginning inventory plus purchases during the period, minus ending inventory, equals COGS. If you started with a certain stock, bought more, and counted what remains, the difference is what was sold at cost. This is why accurate inventory counts matter. An error in ending inventory flows directly into COGS and profit. ## Perpetual or periodic A perpetual system updates inventory with each sale and purchase, so COGS is recorded at the time of sale. A periodic system waits until the end of the period, then uses the formula. Many small businesses start periodic and move to perpetual as software helps. Whichever you use, reconcile your records with physical counts. ## Common mistakes Putting inventory purchases straight to expense, so COGS is overstated in the buying month, is a common one. Another is leaving freight and duties out. A third is misclassifying a direct cost as overhead, which makes gross margin look better than it is. If you sell services, decide which costs rise and fall with jobs, and keep that classification stable. ## Why it matters Gross margin depends on COGS. Watching it by product or service line shows what is truly profitable. It is also part of your tax return, so inventory methods and counts need support. Review COGS as a percent of sales every month. A rising percentage may signal supplier price increases, waste, theft or discounting. Share your method and counts with your tax preparer, since different rules apply to certain small businesses, and your CPA can confirm what you must use. ## A quick example A shop starts the quarter with stock valued at a set amount, buys more during the quarter, and counts what is left at the end. Add the beginning stock to purchases, subtract the ending count, and the result is COGS. If sales were higher than that figure by a healthy margin, the shop is covering its direct costs. If the margin is thin, the owner can test price changes, supplier quotes or packaging costs before overhead gets involved. If your COGS percentage moves, drill into the pieces: purchases, freight, labor and inventory change. One piece usually explains most of the movement. Documenting the explanation each month builds a record that helps with pricing and with year-end tax work. ## Check your work (with numbers) Say you start the quarter with $8,000 of inventory, buy $14,500 more during the quarter and count $9,300 on hand at the end. Cost of goods sold is $8,000 + $14,500 - $9,300 = $13,200. If your books show COGS of $14,500 (purchases only), profit is understated by $1,300 because you never subtracted the growth in inventory. Then test the margin. If sales were $31,000, gross profit is $31,000 - $13,200 = $17,800, or about 57.4%. Compare that percentage to prior quarters. A sudden drop usually means unrecorded purchases, a counting error, shrinkage, or prices that did not keep up with costs. Finally, tie the ending inventory to the physical count sheet and the balance sheet line. If those three numbers differ, fix that before trusting any margin. ## Common questions **Is shipping to customers part of COGS?** Usually outbound shipping is treated separately from inventory cost. Ask your CPA how to classify it. **Do service businesses have COGS?** Many do, such as subcontractors and job materials. Others report only operating expenses. **Can COGS be negative?** Not normally. A negative figure suggests an inventory or entry error. This guide is general information, not tax, legal or accounting advice. Rules, fees and due dates change; check with the IRS, the NJ Division of Taxation or a licensed professional for your situation. Let us handle it [### Monthly bookkeeping Categorizing, reconciling and monthly reports, with cleanup, payroll and NJ filings available. Bookkeeping →](/bookkeeping/) [### QuickBooks Online Monthly bookkeeping, cleanup and reconciliation in QuickBooks Online for New Jersey small businesses. Your account stays in your name. 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